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Gold: Great risk-reward opportunity setting up

Please read the Disclaimer before reading this article.

It has been three months since I wrote an article purely dedicated to gold.

In that article, I explained why I went from being fully positioned in gold, to selling my entire portfolio: “I sold my whole portfolio and went to cash. When the facts change, I change my mind.”

I concluded that article by stating that it would take more time before the next leg higher in gold would start: “So, is the bull market in gold over? Certainly not. But probabilities suggest that the next sustained move higher won’t be starting in the short term.”

At the end of February, I tweeted a thread on twitter showing that long-term technical levels that should have hold, failed.

The following article shows why these levels were so important: link.

The reason gold has had such a difficult time is because of rising interest rates. As I’ve showed in my previous two articles, there is a chance that interest rates have put in a temporary peak.

Now, take a look at the following chart from Mikael Sarwe.

Inflation is going to explode in the coming months.

Source Mikael Sarwe, Nordea

What if interest rates have already discounted a big part of this move higher in inflation that’s coming? This would imply that inflation would rise more rapidly than nominal rates, which would lower real rates and would thus be bullish for gold.

You could also argue the opposite. Nominal rates have already risen a lot but given the (temporary?) inflation that’s coming in the next few months, this move is not yet over. Nominal rates will continue higher and pressure on gold will remain.

Are there historical episodes where inflation moved sharply higher but interest rates didn’t? The following chart answers the question. As you can see, in 2007 and 2011, inflation rose sharply (blue line) but interest rates declined (black line). I indicated these two episodes in green. This was very bullish for gold.

In the second half of 2016 (indicated in red), inflation rose sharply but so did interest rates and gold got crushed.

Thus, it is perfectly possible that over the next few months, inflation will rise quickly but interest rates will consolidate. This would be extremely bullish for gold.

But how do we know that’s it not the second scenario that will play out? What if interest rates continue to rise?

The following chart shows the trajectory of the ISM and interest rates at the interest rate peaks highlighted above (2007 and 2011).

We can see that the ISM declined in both instances.

In the second half of 2016, when interest rates moved higher, so did the ISM (not shown on this chart).

The following model from Nordea shows that probabilities are high that we haven’t yet seen the peak in the ISM for this cycle.

Source: Nordea: FX weekly: Nothing else matters (than the USD), Martin Enlund, Andreas Steno Larsen

We must remember that in the second half of 2016, the move higher in interest rates started when yields were at their lows.

Given the fact that we have already seen an enormous move high in interest rates, it is my expectation (given the technical picture of interest rates I showed in previous articles) that a consolidation is the higher probability event.

Could I be wrong and is it possible that interest rates just continue to move higher when the inflation prints start to come in? Absolutely.

Luckily, the technical picture of gold is showing an extremely simple risk-reward setup right now.

Let’s first have a look at the big picture weekly chart of gold. As you can see, once the 1780 level failed, gold moved sharply lower.

As long as we are below this level, the bulls have a lot to prove.

The 1780 level served as resistance three times in 2011 and 2012 and last year, the gold price consolidated multiple weeks below this level. Once it broke above, the move to 2000+ gold started.

If we get back above the 1780 level, that will be the point to get back into gold. Until that occurs, expect this level to act as stiff resistance.

If we look at the daily chart, we can see the importance of this level even more clearly (on the daily chart the level to watch is 1770).

So, trading gold is now rather easy in my opinion.

There is a possibility that gold could enjoy an amazingly bullish fundamental backdrop over the next few months. Inflation will rise sharply and historically speaking, interest rates don’t always follow. As we saw in 2007 and 2011, gold did great in those instances.

To know if this scenario is indeed going to play out (and to profit from it), you just have to buy gold (or your favorite gold mining shares, or silver), once gold breaks above the 1770 level. This would be the market signaling that this scenario is indeed going to play out. The risk-reward opportunity is great. (And it's also very easy to risk manage your position with this setup.)

Another thing I’ll be looking at is the price action in Barrick Gold Corp.

If it can get back above the 22.18 level, this will be another confirmation signal that it was a false breakdown.

The only thing we need now is some patience. Don’t rush in and start buying. Wait for the market to confirm this view. As Jesse Livermore said: “The good speculators always wait and have patience, waiting for the market to confirm their judgment.”

Thank you very much for reading my article.

You can follow me on twitter: @adaptiveinvest

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